Hedge Funds

Lecture Outcomes

 List the characteristics of hedge funds.

 Compare the hedge funds with the other traditional portfolio
of investments.
 Videos on Hedge funds
 https://www.youtube.com/watch?v=AuDfoVQuCT4
 Concept
 Pooled Investment Company/vehicle
 An investment made in order to
 reduce the risk/volatility
 of adverse price movements in a security,
 by taking an offsetting position in a related security, such as an option or a short sale.

 A hedge fund is an investment fund that pools capital from high net worth
individuals or institutional investors

 invests in a variety of assets, often with complicated portfolio-construction and risk

management techniques
 A simple hedge fund definition is: a hedge fund is an alternative investment that is

designed to protect investment portfolios from market uncertainty,

 while generating positive returns in both up and down markets. Throughout time

investors have looked for ways to maximize profits while minimizing risk.
 What is a hedge fund?
 Hedge Fund- A fund that can
 take both long and short positions
 use arbitrage
 buy and sell undervalued securities
 trade options or bonds, and
 invest in almost any opportunity in any market where it foresees impressive gains at
reduced risk.
 Can invest in markets such as equities, bonds, OTC products, fixed income,
commodities, credit, currencies and derivatives.
 Characteristics of Hedge Funds

 Organized as private investment partnerships

 Fluctuate extremely in terms of investment returns.
 Utilize different investment styles and strategies
 Portfolio diversification
 Deliver non-market correlated returns.
 Consistency of returns and capital preservation rather
than magnitude of returns.
 Wide trading strategies
 Hedge against trading recessions
 Risk management tool
 Own investment
 Highly specialzed
 Is hedge fund legal in India?

 In India according to SEBI regulations, hedge funds fall under Category 3 of

AIF(Alternate Investment funds). And the requirements to start a hedge fund is too

tight as given by SEBI. ... Not everyone is allowed to invest in a hedge fund. Only

certain certified investors are allowed to invest.

 Hedge Funds in India
 Munoth Hedge Fund
 Forefront Alternative Investment Trust
 Quant First Alternative Investment Trust
 IIFL Opportunities Fund
 Singlar India Opportunities Trust,
 Motilal Oswal’s offshore hedge fund
 India Zen Fund. 
 Here is a list of hedge funds operating in India.
 Indea Capital Pte Ltd.
 India Capital Fund.
 India Deep Value Fund.
 Absolute India Fund (AIF)
 Naissance Jaipur (India) Fund.
 Avatar Investment Management.
 Passport India Fund.
Hedge Funds vs Other
traditional asset classes
 Criteria  Mutual funds
 Absolute Returns  Private equity
 Skill Based investing  Venture capital funds
 Minimum investment levels  Commodity pools
 Liquidity and capacity
 Performance Fees
 Hedge Funds vs Other traditional asset classes

Investment Class Hedge Funds Traditional Investment

Strategies Long and Short Long Only
Performance Absolute Benchmark
Measurement
Positive Returns Independent of behaviour of Conditional on rising
traditional markets markets
Technique Leverage/deleverage Limited use of
leverage/deleverage
Managers own Invested Not invested
investment
Risk Absolute Risk Tracking error
Fees Management and Incentive Management Fee only
Fee
Transparency Often very low Public Information
Distribution
Correlation between Low High
manager
Failure of Hedge funds
 https://
www.investopedia.com/articles/investing/101515/3-biggest-hedge-fund-scandals.as
p
Learning Outcomes

 Explore various fund management strategies of hedge

funds.
 Hedge Fund Manager

 A hedge fund is a way of making money through buying securities, like company

shares, which are traded on financial markets. ...

 The term Hedge Fund Manager often refers to both a firm that provides investment

management services and an individual who directs fund management decisions.

Biggest Hedge Fund

 https://www.valuewalk.com/2020/02/top-10-biggest-hedge-
funds/
HEDGE FUND STRATEGY
Complete strategy of Hedge Fund

 https://www.wallstreetmojo.com/hedge-fund-strategies/
 Long/Short Equity Strategy
 In this type of Hedge Fund Strategy, Investment manager maintains long and short
positions in equity and equity derivative securities.
 Thus, the fund manager will purchase the stocks that they feel is undervalued and
Sell those which are overvalued.
 A wide variety of techniques are employed to arrive at an investment decision. It
includes both quantitative and fundamental techniques.
 Such a hedge fund strategy can be broadly diversified or narrowly focused on
specific sectors.
 It can range broadly in terms of exposure, leverage, holding period, concentrations
of market capitalization and valuations.
 Basically, the fund goes long and short in two competing companies in the same
industry.
 But most managers do not hedge their entire long market value with short positions.
 Example
 If Tata Motors looks cheap relative to Hyundai, a trader might buy
$100,000 worth of Tata Motors and short an equal value of Hyundai
shares. The net market exposure is zero in such a case.
 But if Tata Motors does outperform Hyundai, the investor will make
money no matter what happens to the overall market.
 Suppose Hyundai rises 20% and Tata Motors rises 27%; the trader sells
Tata Motors for $127,000, covers the Hyundai short for $120,000 and
pockets $7,000.
 If Hyundai falls 30% and Tata Motors falls 23%, he sells Tata Motors for
$77,000, covers the Hyundai short for $70,000, and still pockets $7,000.
 If the trader is wrong and Hyundai outperforms Tata Motors, however,
he will lose money.
 Market Neutral Strategy
 By contrast, in the market-neutral strategy, hedge funds
target zero net-market exposure which means that shorts and
longs have equal market value.
 In such a case the managers generate their entire return from
stock selection.
 This strategy has a lower risk than the first strategy that we
discussed, but at the same time, the expected returns are also
lower.
 Example
 A fund manager may go long in the 10 biotech stocks that
are expected to outperform and short the 10 biotech stocks
that may underperform.
 Therefore, in such a case the gains and losses will offset
each other in spite of how the actual market does.
 So even if the sector moves in any direction the gain on the
long stock is offset by a loss on the short.
 Merger Arbitrage Strategy
 In such a hedge fund strategy the stocks of two merging
companies are simultaneously bought and sold to create a riskless
profit.
 This particular hedge fund strategy looks at the risk that the
merger deal will not close on time, or at all.
 Because of this small uncertainty, this is what happens:
 The target company’s stock will sell at a discount to the price that
the combined entity will have when the merger is done.
 This difference is the arbitrageur’s profit.
 The merger arbitrageurs care only about the probability of the
deal being approved and the time it will take to close the deal.
 Consider these two companies– ABC Co. and XYZ Co.
 Suppose ABC Co is trading at $20 per share when XYZ Co. comes
along and bids $30 per share which is a 25% premium.
 The stock of ABC will jump up, but will soon settle at some price
which is higher than $20 and less than $30 until the takeover deal is
closed.
 Let’s say that the deal is expected to close at $30 and ABC stock is
trading at $27.
 To seize this price-gap opportunity, a risk arbitrageur would purchase
ABC at $28, pay a commission, hold on to the shares, and eventually
sell them for the agreed $30 acquisition price once the merger is closed.
 Thus the arbitrageur makes a profit of $2 per share, or a 4% gain, less
the trading fees.
 Convertible Arbitrage
 Convertibles generally are the hybrid securities including a combination of a bond
with an equity option.
 A convertible arbitrage hedge fund typically includes long convertible bonds and
short a proportion of the shares into which they convert.
 In simple terms, it includes a long position on bonds and short positions on common
stock or shares.
 It attempts to exploit profits when there is a pricing error made in the conversion
factor i.e. it aims to capitalize on mispricing between a convertible bond and its
underlying stock.
 If the convertible bond is cheap or if it is undervalued relative to the underlying
stock, the arbitrageur will take a long position in the convertible bond and a short
position in the stock.
 On the other hand, if the convertible bond is overpriced relative to the underlying
stock, the arbitrageur will take a short position in the convertible bond and a long
position in the underlying stock.
 In such a strategy manager try to maintain a delta-neutral
position so that the bond and stock positions offset each
other as the market fluctuates.
 (Delta Neutral Position- Strategy or Position due to which
the value of the Portfolio remains unchanged when small
changes occur in the value of the underlying security.)
 Convertible arbitrage generally thrives on volatility.
 The reason for the same is that more the shares bounce,
more the opportunities arise to adjust the delta-neutral
hedge and book trading profits.
 Visions Co. decides to issue a 1-year bond that has a 5% coupon rate. So on the
first day of trading, it has a par value of $1,000 and if you held it to maturity (1
year) you will have collected $50 of interest.
 The bond is convertible to 50 shares of Vision’s common shares whenever the
bondholder desires to get them converted. The stock price at that time was $20.
 If Vision’s stock price rises to $25 then the convertible bondholder could exercise
their conversion privilege. They can now receive 50 shares of Vision’s stock.
 50 shares at $25 are worth $1250. So if the convertible bondholder bought the
bond at issue ($1000), they have now made a profit of $250. If instead, they
decide that they want to sell the bond, they could command $1250 for the bond.
 But what if the stock price drops to $15? The conversion comes to $750 ($15
*50). If this happens you could simply never exercise your right to convert to
common shares. You can then collect the coupon payments and your original
principal at maturity
 Capital Structure Arbitrage
 It is a strategy in which a firm’s undervalued security is bought
and its overvalued security is sold.
 Its objective is to profit from the pricing inefficiency in the
issuing firm’s capital structure.
 It is a strategy used by many directional, quantitative and
market neutral credit hedge funds.
 It includes going long in one security in a company’s capital
structure while at the same time going short in another security
in that same company’s capital structure.
 For example, long the sub-ordinate bonds and short the senior
bonds, or long equity and short CDS.
 An example could be – A news of a particular company performing
badly.
 In such a case, both its bond and stock prices are likely to fall heavily.
But the stock price will fall by a greater degree for several reasons
like:
 Stockholders are at a greater risk of losing out if the company is
liquidated because of the priority claim of the bondholders
 Dividends are likely to be reduced.
 The market for stocks is usually more liquid as it reacts to news more
dramatically.
 Whereas on the other hand annual bond payments are fixed.
 An intelligent fund manager will take advantage of the fact that the
stocks will become comparatively much cheaper than the bonds.
 Fixed-Income Arbitrage
 This particular Hedge fund strategy makes a profit from arbitrage
opportunities in interest rate securities.
 Here opposing positions are assumed in the market to take
advantage of small price inconsistencies, limiting interest rate risk.
The most common type of fixed-income arbitrage is swap-spread
arbitrage.
 In swap-spread arbitrage opposing long and short positions are
taken in a swap and a Treasury bond.
 Point to note is that such strategies provide relatively small returns
and can cause huge losses sometimes.
 Hence this particular Hedge Fund strategy is referred to as ‘Picking
up nickels in front of a steamroller!’
 Event-Driven
 In such a strategy the investment Managers maintain positions in
companies that are involved in mergers, restructuring, tender offers,
shareholder buybacks, debt exchanges, security issuance or other
capital structure adjustments.
 Example
 One example of an Event-driven strategy is distressed securities.
 In this type of strategy, the hedge funds buy the debt of companies
that are in financial distress or have already filed for bankruptcy.
 If the company has yet not filed for bankruptcy, the manager may
sell short equity, betting the shares will fall when it does file.
 Global Macro
 This hedge fund strategy aims to make a profit from large economic and
political changes in various countries by focusing on bets on interest rates,
sovereign bonds, and currencies.
 Investment managers analyze the economic variables and what impact they
will have on the markets. Based on that they develop investment strategies.
 Managers analyze how macroeconomic trends will affect interest rates,
currencies, commodities or equities around the world and take positions in
the asset class that is most sensitive in their views.
 A variety of techniques like systematic analysis, quantitative and
fundamental approaches, long and short-term holding periods are applied
in such cases.
 Managers usually prefer highly liquid instruments like futures and
currency forwards for implementing this strategy.
 An excellent example of a Global Macro Strategy is George
Soros shorting of the pound sterling in 1992. He then took a
huge short position of over $10 billion worth of pounds.
 He consequently made a profit from the Bank of England’s
reluctance to either raise its interest rates to levels
comparable to those of other European Exchange Rate
Mechanism countries or to float the currency.
 Soros made 1.1 billion on this particular trade.
 Short Only
 Short selling is an investment strategy that includes selling
the shares that are anticipated to fall in value.
 In order to successfully implement this strategy, the fund
managers have to scour the financial statements, talk to the
suppliers or competitors to dig any signs of trouble for that
particular company.
Principles of Hedge Funds

 1. Correlation among stocks

 2. Sensitivity of stock with other
Differences Between Hedge
funds and Mutual Funds
Basis for comparison Hedge fund Mutual fund
A trust, where savings of several
The hedge fund is a portfolio of
investors are pooled together to
investments, in which few
Meaning purchase a diversified basket of
qualified wealthy investors pool
securities at low cost, is known as
their money to buy assets.
Mutual fund.
Return Absolute Relative
Comparatively less aggressively
Management Aggressively managed.
managed.
Owners Few Thousands
Pension fund, endowment fund,
Investor type Retail investors
high net worth individuals.
Regulation Less regulation Strictly regulated by SEBI
Based on the percentage of assets
Fees Performance based.
managed.
Ownership of fund
Substantial Not-substantial
manager
Annual reports are published and
Information provided to investors
Transparency semi-annual disclosure of the
only.
performance of assets.